Key Financial Ratios for Retail Companies

The retail industry has numerous financial ratios that assist management with the operations of selling goods. These financial ratios are also useful to investors to determine the long-term security, short-term efficiency and overall profitability of a retail company. Additionally, they can help analyze how well a retail company is selling its inventory, pricing its goods and operating its business as a whole.

The current ratio is measured by dividing a company's current assets by its current liabilities. This financial metric measures the ability of a company to pay off its short-term obligations. A current ratio greater than one indicates that a company can cover its short-term debt with its most liquid assets. To an investor, the current ratio gauges the liquidity and short-term stability of an organization during the potential seasonal fluctuations common to retail.

The quick ratio is calculated by dividing cash and accounts receivable by current liabilities. This ratio is similar to the current ratio, but the quick ratio is more restrictive on the assets that cover the liabilities. For this reason, the quick ratio is a better measurement of the immediate liquidity of a company. If a company is forced to liquidate its assets to pay its bills, companies with a higher quick ratio measurement are forced to sell fewer assets. From an investor's standpoint, the quick ratio provides insight into the stability of the immediate liquidity position of a company.

The gross profit margin is a profitability ratio that is calculated in two steps. First, the gross profit is calculated by subtracting cost of goods sold (COGS) from net revenue, and then the gross profit is divided by net sales. This metric is insightful to management as well as investors regarding the markup earned on products. From an investor's standpoint, higher gross profit margins are preferable, since a piece of inventory generates more revenue when it is sold for a higher gross profit. Because all items in a retail company are inventory items, the gross profit margin relates to every item in a retail store.

Calculated by dividing net sales for a period by the average inventory balance for the same period, inventory turnover is a measurement of the efficiency of inventory management. Retail companies have inventory on hand to secure and protect. Additionally, older inventory may become obsolete. For this reason, a higher inventory turnover is favorable for management as well as investors. A low inventory turnover indicates a company is inefficiently holding too much inventory or not getting large amounts of sales. Alternatively, an inventory turnover ratio can be too high. For example, a large ratio may indicate a company is efficiently ordering inventory, but not receiving ordering discounts.

Return on assets (ROA) is a profitability measurement that gauges how well a company is using its assets to generate revenue. This is especially important for a retail company, as it relies on its inventory to generate sales. The financial ratio is calculated by dividing a company's total earnings by its total assets. An investor can compare a retail company's ROA to industry averages to understand how effectively the company is pricing its goods and turning over its inventory. For example, the retail apparel industry reported an average ROA of 19.39% in the third quarter of 2015. If a company in this industry calculated a metric of 10%, it may be carrying too much inventory or not charging high enough prices compared to its competitors.

The interest coverage ratio is calculated by dividing earnings before interest and taxes (EBIT) by the average interest expense. A retail company may be charged an interest expense for the rent or lease of goods, equipment, buildings or other items necessary for operations. The interest coverage ratio determines how well a company can cover the interest charged for a period. An investor can use this ratio to determine the stability of a company, as well as how well it can cover its interest charges.

The EBIT margin measures the ratio of EBIT to the net revenue earned for a period. A company can utilize this financial ratio to determine the profitability of goods sold without having to factor in expenses that do not directly affect the product. Although the EBIT margin still figures in administrative and sales expenses, it removes a few expenditures that may skew the perception of the profitability of a good. From an investor's standpoint, the EBIT margin gives an indication of a company’s ability to earn revenue.